Thoughts on executive pay and income inequality
Does an economic system that bases compensation on productivity, leading to a huge income gap, meet the test of basic fairness and justice? Or are we seeing—like the Boston Red Sox destroying a local Little League team—unfair and predetermined outcomes?
Since the American federal government started offering bailouts to banks, other financial institutions and even automakers, public outcry over executive compensation has continued unabated. "Why should we, the taxpayers, subsidize the excessive (outrageous, hideous, obscene) pay of the very people who drove their companies to the point of bankruptcy?" goes the cry. Though this populist sentiment was fueled in large part by the fulminations of self-righteous politicians and media commentators, the question raised in this context is legitimate: Why, indeed, should taxpayers subsidize multi-million bonuses for executives who seek huge government bailouts after mismanagement and excessive risk taking?
Public concern about this issue will fade away rather quickly as bailout monies are returned to the government. What will not go away—nor should it—is the deeper and more troubling issue of growing income inequality in the United States. Salary trends over the last thirty years show a significant rise in income inequality, with wages more or less stagnant at the bottom (adjusted for inflation), but growing dramatically at the top. In the 2008-09 edition of The State of Working America, authors Mishel, Bernstein and Shierholz report that the ratio of the average CEO salary to the salary of the average worker in the company rose to 275 to 1, up from 35 to 1 in 1978. According to the Congressional Budget Office, the share of total income earned by the top 10% of households increased from 30.5% in 1979 to 41.6% in 2006. The share of the top 1% of households increased from 9.3% to 18.8% over the same period.
What has caused this growing inequality? Economic theory teaches that in market systems, salaries depend on the value we add to the firm—that is, our (marginal) productivity. The more productive we are, the more valuable we are to the firm, and hence the greater our compensation. Following the industrial revolution, the key driver of income growth was access to physical capital—machines—that allowed workers to be more productive, and thus more valuable to an employer. Today, a worker's productivity is driven more by knowledge and skills (human capital) than by physical capital. Those with unique skills and technical knowledge are in high demand and therefore paid huge sums by employers. This extends to those who possess unusual athletic ability (skills), as well as popular singers, actors and television personalities. It also includes the relatively small pool of individuals who are capable of running a multi-billion dollar corporation. Those with minimal human capital, the unskilled and poorly educated, are of little value to employers, and thus receive low salaries, if they are lucky enough to land a job.
Does an economic system that bases compensation on productivity, leading to a huge income gap, meet the test of basic fairness and justice? Differences in individual capabilities and life choices mean that some degree of economic inequality is consistent with justice. For example, physicians who have spent eight years in college and medical school, often incurring huge debt in the process, are justly paid substantial salaries. The services they provide to society are highly valued, and because of this they justly earn more than less skilled medical workers. In professional sports, there are few superstars—like Alex Rodriguez of the New York Yankees—who can command $33,000,000 per year. Yet given his talent, and the willingness of fans to pay high ticket prices to see him perform, his high salary is not unjust.
Market system proponents sometimes compare the market process to a competitive game, with a set of rules. If the rules are not rigged to favour one group over another, and participants follow the rules, then the outcomes are deemed fair. Some will do well, earning high incomes, while others will do badly, earning far less. That's what happens when we enter a competitive game. If the batter strikes out swinging, he can't claim unfairness, unless the pitcher broke the rules by throwing, say, an illegal spitball.
The problems with this analogy are twofold. Generally speaking, in a baseball game, teams enter the contest on relatively equal terms. All of the players are of major league quality and both teams have a reasonable chance of winning. But in the "market game" participants enter the competitive arena with vastly different amounts of human capital. Some enter with education from the best private schools followed by degrees from the top colleges and universities. Others enter after attending poor quality, underfunded, inner city schools from which they drop out at age 16. Is this game fair? I think not. It's the equivalent of the Boston Red Sox playing the local Little League team. The game might be played according to the rules, but the outcome is predetermined.
What should we do? The goal should be to insure a minimum level of human capital for all. Though by no means a panacea, an important step would be the adoption of a voucher system for education, allowing parents to send their children to the school of their choice, including religious schools. A good education is no guarantee of future success, but it is almost always a necessary condition. We also need real education reform in the public schools of America and Canada. This will require greater funding for schools in poor communities, and expanded opportunities for vocational education. Expansion of community college programs teaching job skills should also be on the agenda.
A second problem with the game analogy is in the setting of the rules themselves. In some cases executive compensation seems quite unrelated to the success of the firm, and thus CEO productivity. The rules that apply to the rank and file don't seem to apply to those at the top. CEOs are often allowed to select the peer group of firms that the board compensation committee will use for comparison. Stockholders have found it difficult to express to corporate boards their concern about executive salaries or huge payouts upon the termination of an executive's employment.
Careful examination of these and other issues in the structure and governance of corporations will need to be made, and appropriate reforms adopted, to regain public trust.